Tax delay, Fed paring called threat to JGB bubble

Takeshi Fujimaki, a former adviser to billionaire investor George Soros who won a seat in the Upper House election last month, said a delay in increasing the sales tax and a reduction in the U.S. Federal Reserve’s stimulus could cause the Japanese government bond “bubble” to burst.

Prime Minister Shinzo Abe’s administration plans to release later this year its medium-term fiscal plans and a final decision on a two-step doubling of the consumption levy to 10 percent in 2015. Fed Chairman Ben S. Bernanke said in June the U.S. central bank may start scaling down its third round of quantitative easing this year and end the asset purchases altogether in mid-2014.

Japan’s public debt, the highest ratio globally, may balloon to 245 percent of gross domestic product this year, according to the International Monetary Fund. Even as the nation struggles to turn its primary balance into a surplus, it enjoys the world’s lowest borrowing costs as record bond buying by the Bank of Japan helps keeps yields anchored.

“The JGB market is in a bubble and the tapering of QE in the U.S. or cancellation of the planned tax hike could become a thin needle to prick it,” Fujimaki, 63, who won his seat on the Nippon Ishin no Kai (Japan Restoration Party) ticket in the July 21 ballot, said Wednesday in Tokyo. “Japan will not be able to avoid default and hyper-inflation with the tax increase, but that’s no excuse for politicians to not go ahead with it.”

In the fiscal year that began in April, the primary balance fiscal deficit will be ¥23.2 trillion, the Finance Ministry estimated in January. Japan is considering an ¥8 trillion ($81 billion) target for budget-deficit cuts over the next two years, according to two officials who asked not to be named in line with government policy.

Abe said July 27 that he’ll make an “appropriate decision” on the first stage of the tax hike, which is due to raise the 5 percent rate to 8 percent next April. The Cabinet Office estimated last August that a 1 point increase in the levy would result in about ¥2.7 trillion in extra revenue.

The yield on Japan’s 10-year bonds was 0.795 percent Thursday. The benchmark rate touched a record low 0.315 percent on April 5, the day after the BOJ unveiled a radical plan to purchase more than ¥7 trillion in Japanese debt a month, and jumped to a one-year high of 1 percent by May 23.

“Japan’s fiscal health is not ringing alarm bells in the market as the BOJ’s enormous amount of bond buying keeps yields low,” said Fujimaki. “No matter how much the government splurges on fiscal spending, the pain won’t be felt, so the debt continues to balloon to the point of no return.”

The cost of protecting JGBs for five years with credit default-swaps was at 63 basis points Thursday, after dropping to a two-month low of 62 on July 18, according to data provider CMA, which is owned by McGraw-Hill Cos. The contracts fall as perceptions of creditworthiness improve.

“Postponing the sales tax would be a huge mistake,” said Fujimaki, who previously served as managing director and treasurer at the Tokyo office of Morgan Guarantee Trust Co., which later merged into JPMorgan Chase & Co. “That would be a clear signal for a government bond selloff, or buying of puts. It could be a trigger for hedge funds which have been waiting for a collapse to start moving.” A put option is an agreement that gives the buyer the right to sell a specific quantity of a particular security by a specific date.

Hedge fund manager J Kyle Bass, whose Hayman Advisors made $500 million during the U.S. subprime mortgage crisis, has predicted a Japanese fiscal collapse since 2010.

“Abe and the BOJ face what I call the ‘rational investor paradox,’ ” Bass told Bloomberg News in an email in May. “If JGB investors begin to believe that ‘Abenomics’ will be successful, they will ‘rationally’ sell JGBs to buy foreign bonds or equities,” referring to Abe’s economic policies. That would place upward pressure on Japanese bond yields and government debt-service costs.

As the BOJ is set to soak up half of the government bonds planned for sale this fiscal year, domestic investors are venturing overseas for higher-yielding assets. Japanese were net buyers of foreign debt for a fourth straight week, according to figures released Thursday by the Finance Ministry. They bought ¥233.2 billion in overseas bonds and notes in the seven days that ended July 26.

Sumitomo Mitsui Financial Group Inc.’s lending unit almost halved its JGB holdings to ¥11.5 trillion in the quarter through June, according to the company’s earnings presentation this week. Mitsubishi UFJ Financial Group Inc. pared its holdings by 17 percent over the quarter to ¥40.3 trillion and Mizuho Financial Group Inc. reduced the amount by 20 percent to ¥24.6 trillion.

“As we can see from the megabanks that are drastically reducing their JGB holdings, there are some company managers with a reasonable mind,” said Fujimaki. “The risk of a default is shifting from the private sector to the public as the BOJ splurges on JGBs. If we continue down this path the credibility of the BOJ will be lost and the yen will plunge.”

The BOJ aims to boost the monetary base, which is cash in circulation plus reserves financial institutions have on deposit at the central bank, to ¥270 trillion by the end of next year to achieve its 2 percent inflation target.

Consumer prices, excluding fresh food, rose 0.4 percent in June from a year ago, the biggest annual rise since November 2008, the statistics bureau said July 26.

“We need a weaker yen to stoke inflation,” said Fujimaki. “The yen’s fundamentals suggest to me it should be around 180 to 200 per dollar. Because it has been around 80, we’ve had 20 years of deflation.”

“It’s impossible to avoid a default at this point, but what’s important is to create a system to avoid the same mistake, and that’s where I can contribute as a politician,” Fujimaki said. “I want to be the part of writing the blueprint to the system for the next 100 years where we have an equal amount of spending and revenue.”